Hearings and Business Meetings

Sep202005

SD-366Energy Committee Hearing Room10:00 AM

Dr. Anne Smith

Prepared Statement ofAnne E. Smith, Ph.D.before theCommittee on Energy and Natural ResourcesUnited States SenateWashington, DCSeptember 20, 2005Mr. Chairman and Members of the Committee:Thank you for your invitation to participate in today’s hearing. I am Anne Smith, and I ama Vice President of CRA International. Starting with my Ph.D. thesis in economics atStanford University, I have spent the past twenty-five years assessing the most costeffectiveways to design policies for managing environmental risks. For the past fifteenyears I have focused my attention on the design of policies to address climate change risks,with a particular interest in the implications of different ways of implementing greenhouse(GHG) gas emissions trading programs. I thank you for the opportunity to share myfindings and climate policy design insights with you. My written and oral testimony todayis a statement of my own research and opinions, and does not represent a position of mycompany, CRA International.I would like to start by summarizing what I think are the most important and overarchingconsiderations that should be accounted for in devising a sound and effective policy tomitigate risks of climate change. I will then provide a basis for these points, present moreextensive detail on the trade-offs in policy design alternatives, and summarize results ofanalysis my colleagues and I have done of the comparative costs and effectiveness ofproposals now before the Congress.The key points that I have to offer about designing an effective climate change policy are:• The linkage between near-term domestic GHG reductions and real reduction ofclimate change risk is, for all practical purposes, nonexistent. Near-term domesticcontrols cannot have any meaningful impact on global emission levels at any costthat is currently deemed realistic. Such policies also will not stimulate the kinds oftechnological progress necessary to enable meaningful emissions reductions later on(because one can expect that carbon prices will be driven to the lowest levelnecessary to incentivize adoption of important new technology – a level that is toolow to provide innovators with a return of their one-time investment cost).• The current debate about how to impose ineffectual near-term controls isencouraging policy makers to neglect much more important, more urgently neededactions for reducing climate change risks. The top priority for climate change2policy should be a greatly expanded government-funded research and development(R&D) program, along with concerted efforts to reduce barriers to technologytransfer to key developing countries. Neither of these will be easy to accomplisheffectively, yet they are receiving minimal attention by policy makers.• Developing new technologies is crucial and it will require long-run, high-risk, highcostR&D to produce radically new GHG-free energy sources. Even withmoderately expensive GHG limits, the private sector will under-invest in this kindof R&D, and only government can provide the needed R&D investment. Theexisting climate policy proposals, including the McCain/Lieberman (M/L) Bill andthe NCEP or Bingaman proposals, focus on providing subsidies to existingtechnologies rather than R&D aimed at developing new technologies. Newgovernment efforts to pick winning technologies and subsidize their deploymentwould probably undermine the cost-effectiveness of any emissions control program,without producing the forward-looking R&D that we really need.• Although no near-term emissions control program will have much impact onsolving the climate problem, a price on carbon in the near-term can be justified as asupplement to a meaningful R&D mission once that mission has clearly definedtargets for success. The near-term control program’s role would be to stimulateemissions reductions that can be achieved now more cheaply than the present valueof future control costs targeted by the R&D program; the maximum near-termcarbon price could therefore be determined by discounting the R&D program’sdefined targets for technology costs and dates of commercial availability.• The design of such a policy for near-term emissions control matters tremendously.CRA’s modeling work and the economics literature indicate the relative costeffectivenessof the various options for the climate change situation.a. Hard caps are the most costly and least desirable option.b. The safety valve approach and carbon taxes are alternatives to hard caps thatare much less costly, and that are more consistent with the inherentlysubsidiary role of any near-term reductions program. (The contrast betweena safety valve and hard cap approach is especially evident in my comparisonbelow of results of CRA’s modeling of the McCain/Lieberman Bill and thecap program of the Bingaman Amendment.)c. One factor highlighted by CRA’s work but often slighted in other analysesis the possibility of using allowances to limit the costs of controls. DomesticGHG controls will cause small but not trivial losses of government revenue.Auctioning some of the allowances and using proceeds to offset otherexpected reductions in Federal revenue would noticeably reduce theprogram’s total cost to society.d. There are no simple analytical methods for determining allocations ofallowances to individual companies or sectors to equitably mitigate thefinancial impacts of the policy.e. There is no allocation design that can make all affected parties better offunder a cap-and-trade or other carbon pricing policy.3f. The inherent complexity of a safety valve approach does not appear to bejustified compared to a simpler carbon tax. A carbon tax would provideidentical emissions reduction incentives at identical costs to those of thesafety valve proposal without the political, institutional, and analyticalcomplications apparent in today’s safety valve proposals.To provide a foundation supporting the above statements, I will begin with a review of thebasic elements of climate science and projections of future greenhouse gas emissions thatare relevant to economic questions about the design of climate policies. In section 2, I willdescribe the range of potential policy designs, which include carbon-pricing schemes andtechnology strategies. Section 3 will focus on just the carbon-pricing approaches in moredetail, and will include a comparative analysis that my colleagues and I have done of thecosts and effectiveness of proposals now before the Congress. I will address costs andrisks to the economy from different policy designs, the ability of economically feasiblemandatory caps on emissions to accomplish long-term climate goals, the role of allocationsin policy design, and alternatives to “mandatory limits on greenhouse gas emissions.” InSection 4, I will turn to technology strategies. I will explain the reasons for my conclusionthat the most important first step for the Congress to take in developing a cost-effective USclimate policy is to provide incentives for R&D into new energy technologies.In all of the following, I wish to be clear that I use the term R&D as a distinctly differentconcept from providing subsidies for the initial uptake of existing but yet-to-be deployedtechnologies. By R&D, I mean investment to create technologies that do not exist today,and which would require major new scientific breakthroughs before they could become anoption that any private entity might consider proposing in a competition for actualimplementation under a subsidy program. The R&D may entail basic science as well aswork that is identifiably on an energy technology with low or zero carbon emissions.Subsidies are aimed at bringing technologies into the market, and by definition, suchtechnologies must be already reasonably well developed, if not yet cost-effective to useunder current prices without supporting funding. There may be a sometimes unclear linedividing the two, but it is clear that we do not yet have enough forms of energytechnologies that could, as a group, provide a carbon-free energy economy at anyreasonable cost. Creating that capability should be the mission of an R&D program.1. Key Points from Climate Science and Global Emissions ScenariosThe key points from climate science and emissions scenarios that are critical to theeconomic analysis of policy options are:• Increases in global average temperatures are related to the concentration ofgreenhouse gases in the atmosphere. Once emitted, greenhouse gases remain in theatmosphere for many decades, so cumulative emissions over a long period of timedetermine changes in greenhouse gas concentrations. As a result, climate changerisk is a function of cumulative greenhouse gas emissions, not emissions in anygiven year.4• Discussions of long-term objectives for climate policy usually focus on stabilizinggreenhouse gas concentrations at some level, so as to limit temperature increases.The concentration of greenhouse gases in the atmosphere will continue to increaseas long as there are net additions of greenhouse gases. To achieve stabilization ofconcentrations and temperature at any level will require that average economy-widegreenhouse gas emissions be reduced to nearly zero.• Given the scale of projected increases in global greenhouse gas emissions,achieving zero net carbon emissions by the middle of the next century will requireproducing at least as much energy as is now produced from all sources by means ofprocesses that have near-zero net carbon emissions. It is not possible to accomplishthis with current technologies at anything close to the current or projected cost ofenergy produced from oil, natural gas, and coal.• Within the next decade or two, developing countries will overtake the industrialworld in total greenhouse gas emissions, so that by 2025 more than half of globalannual emissions of greenhouse gases will be coming from developing countries.Thus no long-term objective of climate policy can be achieved without effectiveactions to reduce emissions from developing countries. Moreover, comparison ofgreenhouse gas intensity between developing and industrial countries suggests thatthere is a large potential for near-term emission reductions in developing countriesat costs far lower than comparable emission reductions in the United States andother industrial countries.These features of the climate problem have some very strong implications for policydesign. Since only cumulative emissions over long time periods matter for climate risk,mandatory caps that place specific limits on near-term emissions in each year createsignificant cost risks without accompanying benefits. Near-term limits on greenhouse gasemissions require the use of current technology for reducing greenhouse gas emissions, andas I will discuss in Section 4, they provide no credible incentive for research anddevelopment aimed at wholly new and more affordable technologies.Nearly-zero greenhouse gas emissions cannot be achieved with current technologieswithout massive disruption to standards of living. Once technologies are developed thatcan make massive emissions cuts affordable (even if still quite costly) then it will bepossible to “make up for” reductions that we might not undertake today. Therefore theonly reductions in emissions that make sense economically until zero-carbon energybecomes affordable as the mainstay of our energy system are those that are very cheapnow.1These considerations suggest that the most important long-term feature of any policyinitiative is the impact it will have on investment in R&D and the development of newtechnologies to provide essentially carbon-free energy at an affordable cost. For near-termemission reductions, the most cost-effective emission reductions available today are in1 Their cost should be less than the present value of the cost of “making up” for them when the zero-carboneconomy becomes viable. For example, if nearly all GHG emissions could be eliminated or offset at$25/tonne CO2-equivalent starting in 2050 (i.e., $93/tonne carbon-equivalent), then the most that it makeseconomic sense to pay for emissions reductions in 2010 is about $3.60/tonne CO2-eq. (or $13/tonne carboneq.),using a 5% real discount rate.5developing countries, placing a high priority on near-term control policies to bring aboutchanges in how energy is used in developing countries.2. Overview of Range of Available Policy ApproachesProposed approaches for climate change policies that involve a commitment by thegovernment to bring about changes in future greenhouse gas emissions include:• Pure cap-and-trade• Cap-and-trade with a safety valve• Carbon tax• An R&D-focused “technology strategy”• Market transformation and technology transfer in developing countriesThese policy approaches form a continuum, all of which can be implemented in a marketbasedmanner. At one end of the scale are policy designs that impose specific, rigid limitson greenhouse gas emissions on specified dates. These are the pure cap-and-tradeprograms, which place a cap on emissions and allow trading of allowances betweenregulated parties to create an incentive for choice of the most cost-effective mitigationoptions. Much attention has been paid to these designs, which have been used successfullyin other environmental areas such as the Acid Rain program (Title IV) of the Clean AirAct. The McCain/Lieberman amendment to the 2005 Senate Energy Bill (S.1151) falls inthis category.The rigidity of emission limits is progressively loosened in proposals for combining capand-trade with a “safety valve” or for simply using a carbon tax to penalize the use of allfossil fuels in proportion to their carbon content. Both safety valve and carbon taxapproaches avoid the imposition of a rigid cap, and instead rely on the economic incentiveof putting a price on carbon emissions to achieve changes in emissions levels.An R&D-focused technology strategy would commit the Federal government to supportingthe research to create new technologies whose adoption in the future will enable muchlarger and more cost-effective emission reductions than are possible today; this also can,and should be designed in a market-based manner.Thus, even now, the Congress is looking at a continuum of proposals, with the most rigidbeing the M/L Bill with its specific targets and timetables for near-term reductions, and theleast rigid and potentially most cost-effective being a focus on devising and implementing amajor and comprehensive R&D program to produce affordable, zero-emitting technologythat will be possible to adopt on a massive scale, throughout our economy and that of theglobe.The pure cap-and-trade approach places the highest priority on achieving fixed andpredictable emission reductions, and accepts whatever the cost of achieving those emissionreductions may be. The pure carbon tax limits the cost of achieving emission reductions tobe no greater, per unit of carbon removed, than the tax. The emission reduction achievable6from a carbon tax is uncertain, because it depends on how much emission reduction ispossible at a cost equal to or less than the tax. Thus the carbon tax places the highestpriority on cost containment, while tolerating some uncertainty in the level of emissionreductions to be achieved. The safety valve becomes indistinguishable from a carbon taxonce the price limit on emission allowances is reached.Technology policy and policies toward developing countries address the two features ofclimate policy that are not addressed by mandatory limits on near-term emissions. These, Iwill suggest, offer far more potential for cost-effective emission reductions in the near andlong term, and are appropriate places for Congress to consider immediate action.This Congress has considered proposals in four out of these five categories. The proposedMcCain/Lieberman amendment to the Senate Energy Bill of 2005 fell in the first category,of mandatory caps. Proposals by the National Commission on Energy Policy (NCEP) andSenator Bingaman (S.A. 868) fall into the second, safety valve, category. An approach toreducing emissions from developing countries was passed into law as Title XVI of theEnergy Policy Act of 2005, along with some of the elements of a technology strategy.Only carbon taxes per se are not talked about in Washington, but the choice betweencarbon caps and carbon taxes is a very important one in the literature on climate policy.I do not believe it is appropriate to narrow consideration at this time to only “mandatory”programs in the sense of binding caps on specific schedules, which if taken literally wouldinclude only the McCain/Lieberman proposal. Although used and justifiable in otherenvironmental areas, this is not the most suitable policy design for climate change. Costsof large near-term reductions are high, mandatory caps create large risks and uncertaintyabout cost, and even mandatory caps cannot provide a credible incentive for R&D todevelop needed technologies. Safety valve proposals, which become indistinguishablefrom carbon taxes once the safety valve becomes effective, offer additional flexibility andneed not imply greater climate risks.Therefore, I would encourage you to include in your thinking about “mandatory” programsall policies that force households and businesses to take into account a cost of greenhousegas emissions. This would recognize that carbon taxes, as well as the NCEP and SenatorBingaman’s approaches, are all “mandatory” approaches to emissions reductions.However, none of the mandatory programs aimed at putting limits on future carbonemissions will provide a credible incentive for R&D or actions by developing countries.Such mandatory programs are not the only actions that can be taken today. I haveconcluded that commitments to support technology development and bring about change inthe rate of growth of emissions from developing countries are a more effective andappropriate focus for current action on climate policy. To my mind, it makes the mosteconomic sense to start where resources committed to mitigation of climate change canachieve the greatest gains, considering both near-term and long-term outcomes as a whole.Therefore, we should start with a clearly articulated and carefully implemented R&Dprogram for developing affordable zero-carbon emitting technologies. Neither thetechnologies nor the necessary R&D program to create them presently exists.7The first three approaches (pure cap-and-trade, cap-and-trade with a safety valve, andcarbon taxes) all function by placing a direct price on GHG emissions. In the next section, Iwill discuss each of the individually, highlighting their respective strengths andweaknesses. I will then provide comparisons of the outcomes under a pure cap-and-tradeproposal (i.e., the McCain/Lieberman proposal) to those of a proposal that directly limitscosts rather than emissions (i.e., the GHG cap program of the Bingaman/NCEP proposal)to highlight how they tend to differ in their impacts. I complete the next section byaddressing a number of issues related to allocation of allowances that I feel are greatlymisunderstood, yet extremely important if a cap-and-trade approach is selected instead of acarbon tax approach for imposing a price on carbon emissions. The following, and lastsection, will then turn to an important limitation of all approaches that directly priceemissions in the unique situation of climate change policy, and the reasons that an R&Dfocusedtechnology strategy needs to be the first and foremost consideration in any policyto address climate change risks. It is my view that none of the proposed policies to dateproperly address this R&D need. In general, they have confused subsidies with the needfor R&D on new technologies, and for the most part the subsidy programs that have beenproposed are also unnecessary for motivating a least-cost response under a carbon-pricingprogram.3. Approaches that Place a Direct Price on EmissionsA. Pure cap-and-trade with rigid emission limitsEmission caps are enforced, under cap-and-trade proposals, by distributing a set ofemission allowances, limited to the quantitative cap. These emission allowances can betraded, so that emission reductions will occur where they are most cost-effective givencurrent technology. The cost of a cap-and-trade program depends on how tightly the capsare set initially and how they are tightened over time. How emission allowances aredistributed also affects the overall economic impact of this policy approach.Near-term caps, such as those proposed by Senators McCain and Lieberman, can only bemet through use of costly measures based on today’s technology. This raises their costssubstantially compared to a policy sequence in which new and more affordabletechnologies are developed first, so that much larger emission reductions can be achievedat much lower cost.Emission caps, even if never tightened, will become more expensive over time, becauseenergy needs are always growing as population increases and the economy expands.Holding greenhouse gas emissions constant in the face of ever-increasing energy demandrequires going to ever more costly control options. The depth of the cuts required can beseen by comparing business-as-usual, or current-policy emissions to emissions under thecap. Based on the current EIA Annual Energy Outlook forecast for emissions undercurrent policies, the limits proposed by Senators McCain and Lieberman would requiretotal CO2 emissions from covered sectors to be reduced to 15% below current policy levelsin 2010 and 26% below current policy levels in 2020. Continuing the McCain/Lieberman8cap to 2050 would require a reduction of emissions to 48% below current policy levels inthat year. Tightening the cap to a level consistent with current proposals for programs thatcould stabilize greenhouse gas concentrations in the atmosphere would require emissions tobe reduced to more than 80% below what CRA International projects for current policyemissions in 2050.The imposition of rigid limits creates unnecessary cost risks, even in the near-term, becauserigid limits can become very expensive if economic growth exceeds expectations or if costsof measures required to reduce emissions turn out to be higher than assumed. Sinceclimate risks are not affected by variations in emissions from one year to the next, but onlyby cumulative emissions over long time periods, these cost risks associated with rigid capsare completely unnecessary to achieving long-term climate goals.The perception that fixed caps create excessive cost risks is, I believe, widely shared. TheMcCain/Lieberman amendment would have created specific fixed and mandatory caps.Other policy approaches before Congress are based on a recognition that setting this kindof mandatory cap is not the only way to take effective action to address climate change.All the other approaches before the Congress involve market based incentives, but do notplace a rigid cap on emissions. These approaches are more suitable to the nature of theclimate problem.B. Cap-and-trade with a safety valveCombining cap-and-trade with a safety valve has the purpose of reducing the cost riskassociated with the pure cap-and-trade approach. Senator Bingaman and NCEP’sproposals also reflect a concept called an “intensity-based” cap, but this only serves toreduce the expected costs of the policy. The real reason that these proposals have reducedrisk of unexpectedly (and unacceptably) high costs lies wholly in the safety valveprovision.The original concept of an “intensity-based” target is that caps would only be tightened inrelation to economic activity levels. If economic activity is high, an intensity approachwould allow a somewhat looser cap to accommodate the extra need for energy, rather thanto choke it off by having a rigid cap no matter what the level of economic activity.However, as implemented in these two current proposals, the “intensity-based” cap would,in fact, still be an absolute cap, computed up to ten years in advance and rigid thereafter.Its primary novelty is that by computing a cap that is tied to economic growth rather thanhistorical outcomes, it would more gradually phase in the cap’s apparent stringency. Thiscertainly makes such a cap less costly than a tighter cap that prevents any further emissionsgrowth at all. However, as long as the cap is binding at all (which is the intention), there isstill uncertainty on how costly it will actually be to attain, especially given its rigidity overten-year periods. (A cap that is truly flexible from year to year in response to economicactivity outcomes might somewhat mitigate this cost uncertainty, but would requirecontinual, year-to-year updating of allocations. This updating would probably be moredetrimental than helpful in producing compliance planning certainty, while still notassuring that costs of control would remain below some planned level.)9Nevertheless, the Bingaman and NCEP proposals do have much less cost risk than previouscap-and-trade proposals, entirely due to the safety valve provision. The safety valve placesa ceiling on the price of carbon allowances under the cap provision. This would beaccomplished by allowing companies to achieve compliance by paying the safety valveprice to the government in lieu of turning in actual allowances that have been issued.Alternatively, the government could issue more allowances at the safety valve price, whichwould then be turned in along with originally-issued allowances. Either way, the effect ofthe safety valve is to make the cap itself flexible rather than rigid. However, its flexibilityis linked to the cost of control rather than to economic activity per se.In summary, the safety valve is a very important way of minimizing cost risk under acarbon emissions control policy, and it does so by converting the carbon cap into a carbontax if the cost of control to meet the cap is higher than the pre-agreed safety valve price.By design (and also just like a tax), this can alter the amount of emission reduction that isachieved, thus making emissions reductions uncertain instead.C. Carbon taxesOnce the safety valve becomes effective, the environmental outcomes and control costsunder a program based on safety valves become indistinguishable from a carbon tax.However, a carbon tax policy would avoid creating the costs and bureaucracy associatedwith allocating allowances and administering an emission trading and enforcement system.All of these approaches – rigid caps, caps with safety valve, and carbon taxes – share acommon feature of mandatory but market-based emission limitation. They require anemitter to pay for its legal emissions, either by purchasing an allowance, foregoingrevenues from the sale of an allowance it was allocated, or paying a tax. Each createsrevenues, and the choice must be made in designing the policy of who will collect theserevenues and how they will be used. This is the choice between auction and allocation ofallowances under a cap-and-trade system.The safety valve involves the sale of emission allowances for a fixed price. It is equivalentto charging a carbon tax on the use of fossil fuels, with the tax rate set for each fuel basedon its carbon content. Use of a carbon tax would also leave control of how to use therevenues under the normal budget process. In contrast, revenues from auctioningallowances or from selling allowances under a safety valve can be placed outside thebudget process, as they are in both the McCain-Lieberman and Bingaman proposals. Usinga free allocation of carbon allowances to compensate some of those harmed by theimposition of limits on greenhouse gas emissions is also a use of potential revenues thatcould accrue to the government, and removes decisions about that use of revenues from thenormal budget and authorization and appropriation process. This has a very importantinfluence on overall economic costs.The proposed cap-and-trade and safety valve programs are likely to impose higher coststhan a carbon tax. In part, this is true because they are likely to have greater administrative10costs than an explicit tax. But more importantly, by taking revenues outside the normalbudget process, these policy designs eliminate the possibility of using some or all of therevenues to replace taxes that would otherwise have to be raised through other federal taxprograms. As I discuss in subsection E below, not allowing revenues from allowanceauctions to be used to offset impacts of emission limitations on total government revenuessubstantially increases the cost of the Bingaman and McCain/Lieberman approaches.Otherwise, the effects of cap-and-trade with a safety valve and a carbon tax areindistinguishable. Consumers of energy will experience increases in the cost of energy, inone case by the price that energy producers must pay for carbon allowances and the otherby the carbon tax they must pay. The response of businesses and households to thesealtered prices will be identical. Differences will arise only from how potential revenuesfrom the safety valve or carbon tax are utilized.D. Analysis of the costs of mandatory caps and safety valvesIn order to quantify the costs and emission impacts of the McCain/Lieberman andBingaman amendments, my colleagues and I have used CRA’s Multi-Region NationalModel of the U.S. economy.2 This model has been used in a variety of studies over the past10 years, and was used by the National Commission on Energy Policy in its own analysisof the economic impacts of its proposals.We have analyzed a range of estimates for the impacts of the McCain/Lieberman proposal(M/L) and of the carbon cap program in the Bingaman Amendment (BA). For M/L ourrange was based on assumptions about the cost at which a carbon free “backstop”technology will become available and how that cost will drop over time; the availabilityand cost of “offsets” to CO2 emissions in covered sectors; and the choices that will be madeabout long-term emission limits after 2020. For the BA, at the low end of the range, weassume that regulated non-CO2 GHGs are able to be costlessly reduced up to the pointwhere the marginal cost of reducing those other GHGs exceeds the safety valve price,based on marginal abatement cost curves prepared by MIT. At the high end of the range,we assume that non-CO2 GHGs are reduced costlessly only up to the point where theyachieve their own share of the intensity targets. Our baseline or “current policy” emissionstrajectory was based on the AEO 2005 reference case forecast of CO2 emissions, and wasnot varied, though this would be another source of cost uncertainty, especially for the M/Lrigid caps.The form of Senator Bingaman’s carbon cap proposal that we analyzed sets a cap ongreenhouse gas (GHG) emissions from 2010 onward. The cap is to be calculated in 2006so that it will cause greenhouse gas intensity (GHG emissions divided by GDP) to fall by2.4% per year from 2010 to 2020, and then to fall by 2.8% per year thereafter. Therequired improvements in GHG intensity are converted to fixed caps for the next decade bymultiplying the required GHG intensity times the level of GDP in each year that isprojected as of 2006.2 For documentation of the MRN model, see http://www.crai.com/pubs/pub_3694.pdf.11We applied a “safety valve” which allows regulated entities to purchase carbon allowancesfor a price of $7 per ton of CO2 in 2010, escalating at 5% per year (nominal). Both thesafety valve escalation and the annual improvement in GHG intensity can be revised byjoint resolution. The bill requires the President to report to Congress on what othercountries are doing to reduce GHG emissions as a basis for recommending such revisions.The proposal includes some, but not all, emissions of non-CO2 GHGs in the calculation ofGHG intensity and allows banking of allowances for use in future years.We assumed that under Senator Bingaman’s proposal a large fraction of carbon allowanceswill be “allocated” to businesses that face disproportionately large negative impacts, andthat 5% in 2010, rising to 10% by 2020, of the allowances will be auctioned to providefunding for subsidies for the development and deployment of selected energy technologies.Sources of economic impacts. Economic impacts arise from four major sources. Directcosts of complying with emission limitations or of adjusting energy supply and use inresponse to a safety valve/carbon tax are incurred by energy producers and consumers.These costs arise from the necessity of diverting resources from other productive uses toreducing greenhouse gas emissions. The activities involved include substituting morecostly but lower carbon forms of energy for fossil fuels, making investments and incurringhigher costs to improve energy efficiency, and losing the benefits of foregone energyservices.A second set of costs arises from an increased excess burden of existing taxes. Both theBingaman and M/L proposals provide for allocations of allowances and specify howrevenues from allowance auctions will be utilized. They do not allow proceeds to be usedto reduce other taxes. It is widely accepted among economists who study the Federal taxsystem that the current set of income, payroll and corporate taxes impose a deadweight losson the U.S. economy. It has been found in a number of studies that a system of emissionlimits or carbon taxes that raises energy costs effectively increases the burden of existingtaxes on the economy.3 Using the revenues from sale of carbon allowances or from acarbon tax to substitute for revenues that would otherwise be raised through conventionaltaxes can reduce or eliminate this distortion. Allocating emission allowances at no costremoves that ability to reduce the distortions of the tax system and contributes to highercosts, as does reserving revenues for new spending programs that are created by the policy.CRA’s analyses have revealed a need for governments to use allowance auctions under aGHG cap to generate a certain amount of new government revenue to offset likelyreductions in existing tax revenues due to a decline in economic activity from the cost ofthe policy. If such offsetting revenues are not tapped from the value of the allowances,then governments will either have to cut services or else raise existing tax rates. The latteraction would actually exacerbate the costs of the policy, and thereby create an inefficiencydue to tax distortions even while the carbon allowance market may function in a perfectlyefficient manner in achieving cost-effective emissions reductions to meet the cap. Neither3 On the issue of how existing tax distortions are magnified by emission limits, see Larry Goulder, Ian Parryand Dallas Burtraw, “Revenue-Raising vs. Other Approaches to Environmental Protection: The CriticalSignificance of Pre-Existing Tax Distortions,” RAND Journal of Economics, Winter 1997; and Larry Goulderand Lans Bovenberg, “Optimal Environmental Taxation in the Presence of Other Taxes: General EquilibriumAnalyses,” American Economic Review, September, 1996.12of the proposals analyzed provides for any revenues to be used to offset tax base erosion.4Although there are some revenues from auctions and safety valve sales, these revenuesources are earmarked for new spending programs rather than to supplement other, fallingsources of government revenues.A third cost element arises from the transition costs of job search which are triggered bythe changes in real wages and shift in industry structure causes by emission limits or safetyvalve/carbon tax policies. This cost element shows up directly in the results as an increasein transitional unemployment, and contributes to reduced GDP and to lower householdconsumption and welfare.Finally, since MRN is a fully dynamic computable general equilibrium model withforward-looking expectations, the prospect of rising carbon allowance prices and futureeconomic impacts leads households to change their current saving and investmentbehavior. Households reduce their current consumption, in order to save and provide forhigher future income to cover the increasing costs of tighter emission limits and risingsafety valve/carbon taxes. This anticipatory behavior makes future costs show up in thepresent. The banking option included in both M/L and BA also encourages businesses toundertake emission reductions in early years in excess of those required by carbon limits, inorder to avoid even higher future mitigation costs due to tightening emission limits orhigher safety valve/carbon taxes. This also contributes to costs in early years.I provide details of our comparison of the impacts of M/L and BA in Exhibits 1 – 4 at theend of this testimony. Generally speaking, our results suggest that M/L impacts are about 3to 4 times larger than the impacts for the BA cap program. Key economic indicators allfollow this pattern:• For 2010, the GDP loss under BA would be about $21 billion to $34 billion, or a0.1% to 0.2% reduction (compared to 0.3% to 1.0% for M/L). The GDP lossincreases over time, both because the percent impact of BA increases with time, andbecause GDP increases with time.• GDP loss under BA in 2020 is $70 billion to $96 billion. (This compares to $214 to$517 billion for M/L) It reflects a 0.3% to 0.4% reduction in 2020 GDP (comparedto 0.8% to 1.9% for M/L).• Per household consumption losses under BA are $135 to $147 in 2010 and $147 to$164 in 2020. (Comparable M/L losses are in the $450 to $800 range.)• Job losses under BA in 2020 are 281,000 to 326,000 (compared to 793,000 to1,306,000 under M/L).• Reduction in coal output in 2020 is 8% to 11% (compared to 23% to 42% for M/L).• Reduction in refined oil output in 2020 is 2% (compared to 6% - 13% for M/L).4 In very approximate-terms, the share of the allowances that the government would need to offset tax baseerosion and thus avoid exacerbating policy costs appears to be between 30% and 60%. This is based onmultiple scenarios analyzed by CRA International using its MRN model, and apparently has beencorroborated by analyses by Prof. Goulder of Stanford University (personal communication).13• Carbon prices are $13 to 18/tonne C in 2010 and $21 to 29/tonne C in 2020. (M/Lcarbon prices are $47-$130 in 2010and $75-$209 in 2020.)• Under BA, carbon allowance prices hit the safety valve price in 2020 in the highcase and 2035 in the low case.The greater cost certainty associated with the safety valve is apparent in the fact that ourM/L cost ranges are much wider than those we estimated for the BA cap. However, thelower overall costs of the BA cap simply reflect the fact that it imposes a much lessstringent demand for near-term emissions reductions. Over the period from 2020 to 2050BA provides emission reductions that total between one-third and two-fifths (32% to 40%)of those provided by M/L. Since the costs of BA range from 25% to 33% of M/L, thecomparison also illustrates the law of diminishing returns, in that it costs proportionatelymore to achieve the larger emission reductions required by M/L.E. Issues in allocating allowancesAllocations versus auctions. I understand the committee is very interested in the issue ofallocation of allowances under Senator Bingaman’s proposal. This is a feature of policydesign for which there are several alternatives. Senator Bingaman distinguishes betweenauction and allocation. Some allowances would be allocated to parties that sufferdisproportionate harm from emission limits, and some would be auctioned and providerevenues.The first question that the Committee might want to consider is who should control the useof the revenues from any auctioned or safety valve allowances. If revenues are placed inthe general fund, then Congress will retain the ability to make the decisions about how therevenues will be utilized. This will allow Congress to consider all societal needs together,and to balance competing needs as they evolve. To place the proceeds into a Trust Fundthat earmarks them for spending only related to climate policy is tantamount to decidingnow that climate-related spending needs to be separated from all other governmentspending decisions, and given a separate, more elevated priority than all other societalneeds, including future needs that may not be anticipated at present. Public financepractitioners generally frown on the idea of earmarking funds from particular revenuesources to particular purposes, because the amount of money that will be collected from aparticular source is only connected loosely, if at all, to the amount that it is wise to spendon even a related purpose. Thus earmarking is likely to produce either too much or toolittle funding, and it removes the decision about how much should be spent from thenormal budget, authorization, and appropriation process.In this regard, I also note that free allocation of allowances is not the only way to providefor compensation of affected parties. Any compensation that can be achieved by a freeallocation formula could, in principle, be replicated under a 100% auction – it would onlyrequire that the auction revenues be returned to companies by the same formula that wouldhave been used for allocations. Funds could be appropriated to provide compensation forthose disproportionately harmed, or specific tax credits could be enacted. Determininghow to make this compensation using normal budget processes would be no harder than14determining how to allocate allowances under the procedures outlined in SenatorBingaman’s proposal.While general principles of public finance suggest that separation of revenues from such apolicy into a Trust Fund is probably unwise, my personal research has found that such anapproach also could exacerbate the total costs of any carbon-pricing policy, and thus wouldbe inconsistent with principles of minimizing policy costs. Paradoxically, allocating all ofthe allowances at no cost to affected parties, and/or using all of the proceeds from sale ofallowances to fund new spending programs, can lead to far larger costs to the economythan necessary. This policy cost inflation can be averted by using some allowance orcarbon tax revenues to replace other taxes that would have to be raised to meet budgettargets. By allowing carbon policy revenues to flow to the general fund, Congress retainsits ability to determine how much of the proceeds from allowance sales or carbon taxesshould be used for replacement of other tax revenues that can be expected to decline underthe carbon policy.Free allocations cannot compensate all businesses and households. Impacts on householdsand industry are not determined by where regulations are put in place. An upstream systemlike that in Senator Bingaman’s proposal still imposes costs on households and industries.Not all the costs are borne by fuel suppliers, even if they are the point of regulation. Allusers of energy have higher production costs. Some will be able to pass some of thesecosts to their consumers, while others will have little ability to pass costs through, and thebrunt of the financial impact will be borne by their shareholders. In the end, householdscannot pass the costs on to anybody, and they ultimately bear the entire cost, as consumersof higher cost of goods and services, and as shareholders in companies that cannot pass thecosts on.Conceptually, allocations could be used to help compensate the companies that bear anexceptional and unfair burden. We have, in other contexts, estimated the average loss incapital value to owners of assets in aggregated economic sectors such as the oil, gas, coaland electricity generation sectors. However, there is no simple formula to identify exactlywhich companies these are, or what amount of allocation would actually provide for anequitable burden sharing arrangement. Companies within the same economic sector mayface diverse impacts, so that an estimate of the “average” loss of profitability for eachsector may bear no correlation to the sum of losses across the negatively affectedcompanies within each sector. Even if one could identify reasonable allocations to eachsector of the economy, comparable allocations to each company within a sector would havelittle chance of equalizing burdens within the sector. Attempts to analytically identifycompany-specific burdens within a sector would be even more challenging than attempts toidentify needs by sector, as the relevant data are not even publicly available. Thus, theidealized concept of mitigating the impact of the rule on individual companies cannot beestimated quantitatively at the level of detail needed to define company-level allocations,let alone be condensed to a relatively simple formula.It is also important to realize that the energy sectors (including non-regulated entities in theenergy sectors) are not the only sectors that will bear losses of capital value as a result of a15carbon pricing policy. All sectors of the economy will be affected to some degree, as allare consumers of energy to varying degrees. As more and more of the needs to becompensated are recognized, the identification of a “fair” allocations rule will becomeexceedingly complex.More importantly, once it is recognized that needs for compensation include all individualenergy consumers, and not just companies, policy makers will have to realize that it is notpossible to offset losses for everyone through allocations of allowances. The total cost of acap-and-trade system will always exceed the total value of the allowances in that system:• This is because companies must pay (1) to reduce emissions down to the level ofthe cap and also (2) for every ton of emissions that remains after meeting the cap.The value of the allowances equals only the second component of total costs. Atmost, the government can give that entire value back to the companies by freeallocation of 100% of the allowances, but that leaves companies still incurring thefirst cost component, and without any way to compensate them for that cost – whichis the real net cost to society.• It is true that companies may be able to pass some of these two cost components onto their customers, and so directly-regulated companies could be given morecompensation than the cost that their shareholders bear if all of the allowances wereallocated to them alone. However, this only means that a part of the net cost hasbeen spread to other, non-regulated parties, including consumers. They, in turn,would require their share of the allowance allocation to be compensated for the partof the cost that was passed to them. There is not enough value in the allowances tocover all costs to regulated companies if they cannot pass those costs on, andneither can that value cover all the incurred costs after they are divided up andspread throughout the entire economy.Thus, a carbon pricing policy will always impose a real net cost on the economy thatcannot be eliminated through any allocation formula that may be devised. All that anallocation scheme can do is alter the companies and individual consumers that end upbearing the burden of that cost.These challenges in identifying fair allocations are not a result of proposing an upstreampoint of compliance. They would be equally difficult under any downstream or hybridform of implementation. They do, however, present more prominent issues when using acap-and-trade approach than under a carbon tax, because the former system does requirethat a specific decision be made for how to distribute the allowances. (At the same time,needs for compensation and burden sharing would also exist under a carbon tax, and therewould also be equivalent degrees of ability to achieve such compensation under a carbontax.)Administrative costs and bureaucracy for small and distant emission reductions. I haveestimated that under Senator Bingaman’s proposal, the price of carbon allowances wouldrise above the safety valve level between 2020 and 2035. EIA puts this somewhat earlier.16This effectively turns the Bingaman proposal into a carbon tax program, but with the muchhigher costs of an administrative apparatus for issuing, enforcing, and trading carbonallowances that doesn’t actually do anything other than impose a pre-determined price oncarbon emissions.This leads to the question of whether it is desirable to create the bureaucracy andadministrative burden of a comprehensive national emission trading program for the smallreductions that are possible with a safety valve. The main differences between safety valveproposals and simply establishing a federal fuels tax based on carbon content are (1) thatthe safety valve has a greater administrative burden, and (2) the safety valve approachallows revenues that would otherwise go into the normal budget process to be handed outby an executive agency or quasi-government corporation.Thus the government cedes the ability to set overall social priorities for the use of thefunds. Further, it sets the stage for automatically spending whatever is collected onclimate-related technologies, without regard to the need for spending at such a level.Because it is not tied to an R&D program with clearly specified goals and a plan formeeting those goals, much of the spending is likely to result in subsidies on investmentsthat would occur anyway (because they are cost-effective under the carbon price) or oninvestments that are not desirable (because they are only feasible at a cost that is higherthan the safety valve price, which by definition reflects the maximum that is deemedreasonable to spend on near-term emissions reductions).5 The use of an outside entity doesnot solve the problem of creating a good R&D program; but it does mean that Congressloses the opportunity to make those R&D spending decisions directly and transparently.4. The Need for R&D Strategy to Be the Leading Edge of Climate PolicyA. New technology is not encouraged by mandatory limitsAlthough M/L has much more substantial (and uncertain) costs than the BA cap proposal,both proposals have substantial costs. But despite these costs to the economy, neither fixedcaps nor safety valve/carbon tax policy designs can provide an adequate incentive for thecritical piece of the solution – which is creation of radically new technologies. In myopinion, it would be better now to put resources into developing new technologies than inforcing the use of existing technology to achieve relatively small and costly emissionreductions. Creating an effective R&D program will not be cheap, but it ultimately has tohappen if climate risks are to be reduced. The difficult decisions are how much to spendnow, and how to design programs to stimulate R&D that avoid mistakes of the past.5 Nuclear power presents a different situation. Although the technology is nearly zero-emitting (there aresome emissions associated with its fuel cycle), available now, and cost-effective under even a modest carbonpricing scheme, its deployment is hampered by existing policy. Removal of institutional and political barriersto new nuclear generation might be the most important way of enabling existing nuclear generationtechnology to provide cost-effective emissions reductions within the next two decades.17The subsidies to current technology embodied in BA and M/L are not likely to bring aboutthat change in the fundamental direction of R&D, because they are directed at thedemonstration and use of current technology. These subsidies should be carefullydistinguished from funding for R&D. Most subsidies would be unnecessary under acarbon-pricing program, as the market price of carbon due to the cap provides theappropriate financial incentives for the optimal use of the control methods that would thenalso benefit from the subsidies. A well-designed policy to address needs for R&D inentirely new technologies is needed, not subsidies to get existing technologies deployed inthe market place. A very different commitment is needed to create programs that willchange the direction of basic research toward creation of climate friendly, zero carbontechnologies. Subsidies for demonstration and use of currently available technologies donot create incentives for creation of entirely new technologies.In BA, the carbon intensity basis for mandatory caps ensures that they rise gradually, sothat there is little change in emissions for the next decade. The safety valve, by design,takes over from the mandatory cap when its costs begin to rise. By design, the safety valvewill not stimulate the desired level of R&D. By attempting to limit cost to a level deemedtolerable, it eliminates adequate incentives for R&D on new technology.Nor will an adequate incentive be provided if the safety valve were eliminated, now or inthe future. This would provide a trajectory of rising allowance prices and tightening limits.But those future policy results cannot be a credible incentive for current R&D, as I explainnext.B. Carbon pricing programs cannot provide credible incentives for technologydevelopmentWhether cap-and-trade or a carbon tax is the policy approach taken, these mandatoryprograms cannot achieve the most important need in a climate program, which is tostimulate development of the kinds of technologies that alone can make significantmitigation of climate risk possible in the long run.Emission caps are not only premature and risky for the economy. They are not capable ofstimulating the kind of technology development that is an absolute necessity to achieve anyof the objectives of climate policy. Putting a stop to the continued growth of greenhousegas concentrations in the atmosphere requires meeting all of today’s energy needs in a waythat produces zero net carbon emissions, and does so at acceptable cost. That is notpossible with the set of technologies that exist today.Hoffert et al. argue that “the most effective way to reduce CO2 emissions with economicgrowth and equity is to develop revolutionary changes in the technology of energyproduction, distribution, storage and conversion.”6 They go on to identify an entireportfolio of technologies, suggesting that the solution will lie in achieving advances inmore than one of the following categories of research:6M. I. Hoffert et al., “Advanced Technology Paths to Global Climate Stability: Energy for a GreenhousePlanet” Science, Vol. 298, Nov.1, 2002, p. 981.18• wind, solar and biomass• nuclear fission• nuclear fusion• hydrogen fuel cells• energy efficiency• carbon sequestrationCurrently available technologies cannot provide sufficient or low cost reductions to meetthe GHG challenge. Developing that supply will require basic science and fundamentalbreakthroughs in a number of disciplines. The magnitude of possible reductions in the nextdecade or two achievable with today’s technology is dwarfed by the magnitude ofreductions that successful innovation would supply through these routes.7Emission caps cannot provide adequate incentives. Even combined with an allowancetrading system that puts a price on emissions, fixed caps cannot provide the incentives forthe necessary technological change to occur. Thus, efforts to address climate change byimposing costly caps or taxes in the near-term will fail to provide long-term reductions.Additionally, if the R&D externality is being effectively addressed, implementation todayof a cap or tax that will not become stringent until a later date will provide little or nofurther benefit in the form of an “announcement effect.” The only role for near-term GHGcaps or taxes would be to achieve emissions reductions that are justifiable immediatelybecause their cost per ton removed is less than the present value of the cost of avoidedfuture emission reductions that would come from the future technologies, once theybecome available. Any other degree of stringency is unwarranted before R&D issuccessful, and unnecessary to supplement policies that will address the fundamentalmarket failures associated with R&D.Announcements of high future carbon prices to stimulate R&D are not credible, becausethose carbon prices would not be necessary once technologies are developed.8 When newtechnology and new capacity investments are the issue, the only policy strategies thatmatter immediately are those that will increase incentives to invest in R&D, and direct theR&D toward technologies that will create a much larger supply of carbon-free energyalternatives at acceptable costs. Therefore, the only attribute of a cap-and-trade programthat will matter will be the future course of the cap and its implications for future allowanceprices.7 For example, if all of the existing US natural gas-fired combined cycle generating capacity were to suddenlybe fully utilized, we estimate based on our models of the US power sector that current annual US CO2emissions would be reduced by about 80 MMTC – about a 4% reduction in total US GHG emissions – and itwould come at a cost of about $80/tonne C, even if gas prices would not be inflated by the sudden surge innatural gas demand.8 These points are developed in a more rigorous fashion in W. D. Montgomery and Anne E. Smith “Price,Quantity and Technology Strategies for Climate Change Policy.” To appear in Human-Induced ClimateChange: An Interdisciplinary Assessment, Cambridge University Press, forthcoming 2005.

None of the “mandatory” programs under consideration could stimulate the kind of R&D innew energy technologies that is required. The “safety valve” in the NCEP program andSenator Bingaman’s amendment is designed to provide assurance that the price of emissionallowances will not reach economically unsustainable levels. But that policy design causesthe prices to be set at a level far too low to provide an adequate incentive for privateinvestors to develop radically new technologies.To motivate the large R&D investments required, it would be necessary for governments toannounce policies that will lead to high enough implicit taxes on carbon emissions toprovide an adequate expected return on R&D investment. This tax will necessarily exceedthe tax needed to induce adoption of the technology once it is developed. Once affordabletechnologies are produced, a relatively low carbon tax price will be enough to motivatecompanies to adopt the new technologies. That lower carbon price will not be enough tocompensate the investors who paid for the R&D, but it will be enough to get it utilized.Even if laws passed today served to announce a future emissions tax high enough to createsuch an incentive, no future Congress or Administration would keep that commitment oncethe technology was developed. As in the case of patents, there is a tradeoff betweenefficiency in resource allocation and providing an incentive for R&D. A carbon priceabove the level necessary to induce adoption of the new technology will cause avoidabledeadweight losses as all energy supply and use decisions are distorted. Reducing implicitcarbon taxes to the lowest possible level to get the new technology deployed will always bebeneficial to the economy. Therefore, future governments will face irresistible pressure tolet the implicit tax on carbon emissions fall back to a level just sufficient to get the R&Dutilized, taking away all the rewards to innovation.This leads to a fundamental dynamic inconsistency that makes any effort to set emissioncaps or announce future carbon prices sufficient to stimulate R&D not credible. Sinceprivate investors can understand this is the optimal strategy for government – and indeedwould likely be skeptical of the political ability of any government to proceed with whatwill look like “corporate welfare” – they will not be motivated to invest in R&D by anyannouncement of future climate policy.

C. Design of technology policy

What this argument demonstrates is that it is not possible to rely on caps on futureemissions, or on announcements of a safety valve or carbon tax, to motivate R&D todevelop the new technologies needed for long-term reduction of climate risk. This meansthat there is an extraordinarily high priority to designing effective programs to stimulatethat R&D through incentives provided today. I would urge Congress to turn its interest inclimate policy toward a subject it knows well – how to craft a program that will lead toeffective use of private and government funds to carry out the R&D needed to provide theradically new technologies required to stabilize concentrations of greenhouse gases andultimately, global climate.

D. Large opportunities for near-term emission reductions exist in developingcountries

For near-term emission reductions, developing countries offer far larger and more costeffectiveopportunity for emission reduction that mandatory emission limits on U.S.businesses and consumers. There are a number of ways in which the U.S. Congress couldact to increase technology transfer and encourage foreign investment in developingcountries, and these actions could lead to near-term reductions in emission larger than anyof the mandatory limits on U.S. emissions under considerations.The provisions of the McCain/Lieberman and Bingaman Amendment proposals dealingwith developing countries create no mechanism for bringing about changes in thosecountries. A great deal of the difference in greenhouse gas intensity between developingcountries and industrial countries can be explained by fundamental failures of markets andinstitutions in developing countries. Much more cost-effective emission reductions arepossible in the near-term through programs directed at developing countries by focusing onfundamental institutional and market reforms to create the property rights and investmentclimate required for private foreign direct investment and technology transfer.9 Theseneeds are already a focus of the Climate Change Title (Title XVI) of the Energy Policy Actof 2005, which passed into law after the Bingaman Amendment was released. I believethat approach of Title XVI should be followed, and further enhanced if necessary. Themore general and less focused provisions expressed in the Bingaman Amendment proposalare unnecessary additions, and could distract from implementing the more focusedprovisions that already exist as law.